Introduction
Inflation, defined as a sustained increase in the general price level of goods and services in an economy, erodes purchasing power, distorts resource allocation, and affects income distribution. While moderate inflation is often considered a sign of a growing economy, high and persistent inflation undermines economic stability and investor confidence. Therefore, controlling inflation is one of the key objectives of macroeconomic policy. To achieve this, governments and central banks employ a combination of monetary and fiscal measures, each targeting different facets of inflationary pressure. For students of economics and public policy, understanding how these tools work—and when they are effective—is crucial to analyzing economic strategy, stability, and governance.
Monetary Measures to Control Inflation
Monetary policy refers to the use of interest rates, money supply regulation, and liquidity management by the central bank to influence inflation, growth, and employment. Central banks, such as the Reserve Bank of India (RBI), target inflation through various policy instruments, focusing on demand-side management.
1. Increase in Interest Rates (Tight Monetary Policy)
The most common and direct tool to combat inflation is raising the repo rate, which is the rate at which the central bank lends money to commercial banks. When the repo rate is increased, borrowing becomes more expensive for banks, which in turn raise interest rates on loans to consumers and businesses. Higher interest rates discourage borrowing and reduce spending and investment, thereby cooling demand and dampening price pressures.
In tandem, the reverse repo rate—the rate at which banks park their surplus funds with the central bank—is also increased to encourage liquidity absorption from the banking system. This process is aimed at mopping up excess money circulating in the economy, which is often a key driver of inflation.
2. Open Market Operations (OMOs)
Open Market Operations refer to the buying and selling of government securities in the open market by the central bank. To control inflation, the central bank sells securities, thereby pulling money out of circulation. This leads to a contraction in money supply, which helps to temper demand and reduce inflationary pressure.
3. Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
These are regulatory requirements that banks must fulfill. An increase in CRR—the proportion of deposits banks must keep with the central bank—reduces the amount available for lending, thereby curbing money supply. Similarly, a higher SLR (the proportion of net demand and time liabilities to be maintained in liquid assets) limits banks' ability to create credit, further restricting demand-side inflation.
4. Inflation Targeting Framework
India adopted a formal inflation targeting regime in 2016, under which the RBI aims to keep inflation around a target of 4% (±2%). This framework provides clarity, credibility, and transparency to monetary policy, and helps anchor inflation expectations, which is crucial in preventing inflationary spirals.
Fiscal Measures to Control Inflation
Fiscal policy refers to the use of government spending and taxation to influence economic conditions. While monetary measures target liquidity and interest rates, fiscal measures work through public finances—either by reducing aggregate demand or by increasing the supply of essential goods and services.
1. Reduction in Government Spending
One of the most effective fiscal tools to control inflation is cutting public expenditure, especially on non-essential or consumption-heavy projects. When the government spends less, overall demand in the economy falls, easing pressure on prices. This is especially important in demand-pull inflation, where aggregate demand outpaces supply.
2. Increase in Taxes
By raising direct and indirect taxes, the government can reduce disposable income in the hands of consumers and businesses, thereby discouraging consumption and investment. For instance, a higher goods and services tax (GST) on luxury items can help reduce demand for those goods, cooling inflation in that segment. However, care must be taken to avoid overburdening lower-income groups, as regressive taxation can exacerbate inequality.
3. Fiscal Deficit Control
Running a high fiscal deficit (where government expenditure exceeds revenue) often leads to increased borrowing and money creation, which fuels inflation. Therefore, adhering to fiscal prudence—by limiting deficits through better revenue collection and rationalizing expenditures—contributes significantly to inflation control. Mechanisms such as the FRBM Act aim to institutionalize such discipline.
4. Subsidies and Supply-Side Support
To tackle cost-push inflation, especially arising from rising food and fuel prices, the government can offer targeted subsidies or price controls. For instance, subsidizing food grains under the Public Distribution System (PDS) or reducing excise duties on petrol and diesel can lower the cost burden on consumers. Similarly, support to agriculture and infrastructure can improve supply conditions, thus addressing the root causes of inflation.
A Combined Approach: Why Both Are Needed
In practice, controlling inflation effectively often requires coordination between monetary and fiscal authorities. For example, monetary tightening may be undermined by expansionary fiscal policy, leading to policy contradictions. Similarly, during supply-side shocks—such as a spike in oil prices—monetary policy alone may be insufficient, necessitating fiscal intervention.
Furthermore, expectations management plays a crucial role in inflation dynamics. If businesses and consumers expect inflation to persist, they may act in ways that reinforce it—by preemptively raising prices or demanding higher wages. A credible and well-communicated mix of monetary and fiscal measures can anchor these expectations and enhance policy effectiveness.
Conclusion
Inflation control is a complex challenge that requires the careful use of both monetary and fiscal policy tools, each targeting different causes and manifestations of price rise. While the central bank controls inflation by managing money supply, interest rates, and liquidity, the government complements these efforts through taxation, expenditure, and subsidy management. For IAS and MBA aspirants, understanding this dual approach provides the analytical foundation to evaluate macroeconomic stability, policy trade-offs, and governance quality. As global economic conditions continue to evolve—driven by geopolitical tensions, climate shocks, and technology shifts—the need for agile and coordinated inflation management becomes even more critical for sustainable growth.